The chief scientist for the digital currency talks about its appeal—and pitfalls—in a world of fiat money.

Could a virtual currency created by an anonymous Internet hacker someday replace the U.S. dollar? What seems like a ridiculous question has become more intriguing as trading in the digital money called Bitcoin has surged more than 300% in the past year to roughly 60,000 transactions per day.

Gavin Andresen,
the 46-year-old lead software developer for the Bitcoin project, is eager to find the answer. "I'm hoping to learn," he says, whether "a nongovernmental global currency" is possible. "Can you get from where we are to the vision of billions of people all over the world using Bitcoin just like they use any other currency? That's the grand experiment."

Thousands of mostly small online merchants are already accepting payment in Bitcoin, though this virtual currency has no intrinsic value and isn't tied to anything that does. Yet the virtual money that debuted in 2009 with a value of zero and traded for the first time in 2010 at a price of three-tenths of a cent recently changed hands at $97.

For Mr. Andresen, a Princeton graduate who once wrote technical standards for 3-D graphics on the Internet, Bitcoin has already begun to replace the U.S. dollar. In November, the Bitcoin Foundation, where he serves as chief scientist, began paying him in the virtual currency. So far he has persuaded his barber to accept this new money, but only from Mr. Andresen. A haircut costs half a Bitcoin.

ENLARGE

Ken Fallin

The IRS won't accept Bitcoins, but that doesn't mean his salary is tax-free. "I get paid in Bitcoin beginning every month. Taxes are computed based on the dollar equivalent." Luckily, his wife, Michele Cooke-Andresen, is a tenured geology professor at the University of Massachusetts, so their household enjoys some dollar-denominated income.

As Mr. Andresen and I walk down a street in Amherst, Mass., discussing the potential of digital money, almost on cue, an armored-truck driver begins unloading boxes of coins in front of a local bank. "Hauling around heavy boxes of pennies," observes Mr. Andresen, chuckling. "I didn't plan that."

Mr. Andresen's job is to help refine the software that allows Bitcoins to be traded and stored. He finds the work "fun and terrifying." The fun part is developing the ability to instantly do business with anyone on the planet via a computer or smartphone.

To demonstrate the convenience of exchanging the new money, he shows me in a few moments how to set up a digital wallet with a service called BlockChain and then sends me 0.01 Bitcoin, worth about 70 cents at the time he transmits it to my phone. There are plenty of ways to transact digitally with traditional currency too, but Mr. Andresen describes the "huge mess" he encountered when he tried to rent a house in France and was buried in fees and delays in wiring the money. With Bitcoin, "the whole world is now your market."

The terrifying part of his job is that almost all of the current Bitcoin services now use the same software, so that "any change to the core code has potentially disastrous impact. If everybody rolls out a new version and there's some problem with it, the whole Bitcoin payment network could grind to a halt."

Technical glitches, hacker attacks, speculation and fraud have caused wild swings in the dollar price of Bitcoins. Mt. Gox, a Tokyo-based exchange that handles roughly 80% of Bitcoin trading, recently shut down briefly after a denial-of-service attack. The shutdown "popped the bubble," says Mr. Andresen, and the price plunged to $69 from $266.

So trading has been disrupted and Bitcoins have been stolen and lost. But Mr. Andresen says they have been counterfeited only once, and the problem was identified and resolved. It could happen again in the future, he warns, though he believes it is highly unlikely.

"Can you bootstrap a currency when it's doing this crazy price fluctuation thing as people become interested and then become not interested? That's an open question," says Mr. Andresen. "I don't know if we have any baby currencies we can point to and say, 'This is the model you should follow' or 'This is the model that worked.' Definitely experimenting here."

There are key attributes of the Bitcoin model that are attracting a growing following beyond tech hobbyists. Bitcoin offers privacy and, perhaps most important, an easy way to transact business across borders. The currency cannot easily be confiscated by any government—which also makes Bitcoin attractive to criminals, including drug dealers. The criminal appeal is one reason it's not easy to buy Bitcoins. A series of startups created to sell Bitcoins to buyers using credit-card numbers failed after the card numbers turned out to be stolen and the encrypted Bitcoins had been sent off into the ether, never to be recovered. As a result, those wishing to buy Bitcoins now must typically pay fees to wire the money, though startups are working on cheaper and easier ways to trade dollars for Bitcoins.

As for the upside, small online merchants would welcome a global payment standard. For this reason Bitcoin or a similar technology could threaten the power of not just central banks, but banks, period. Unlike online payment services that give people with credit cards easier ways to transact business, Bitcoin works best when avoiding the traditional financial system completely.

But perhaps the most intriguing aspect of Bitcoin—at a time when the world's central banks are creating lots of new money—is the promise that the number of Bitcoins will be capped at 21 million. The software is hard-coded to create that amount over the course of decades, on a prearranged, transparent schedule. Bitcoins are created and awarded when people use powerful computers to solve mathematical puzzles, which become more difficult over time as more people compete to solve them. At the moment, there are more than 11 million Bitcoins in circulation.

Politicians and their appointees are entirely cut out of Bitcoin's monetary loop. This is a significant difference between Bitcoin and government-issued fiat currencies. Federal Reserve Bank of Dallas President Richard Fisher calls the U.S. dollar a "faith-based currency." In other words, its value rests on the belief that the government will not print so many dollars that each one becomes nearly worthless. Like Bitcoin, the world's dollars, euros, yen and pesos carry no guarantees they can be redeemed for gold or some other commodity at a fixed price.

On the other hand Bitcoin, unlike those other currencies, is not legal tender for paying debts. Thus it's not clear to everyone why the world really needs this grand experiment in virtual currency. E-commerce continues to expand using existing payment networks that rely on traditional banks and government-issued currencies. And despite the Fed's extraordinary effort since the financial crisis to push money into the economy, most observers see few signs of inflation. What's the problem that Bitcoin solves?

"I'll use a visual aid," says Mr. Andresen. He opens his wallet and presents me with a gift: a 10-trillion-dollar bill once issued by the government of Zimbabwe. He bought a stack of them online for one Bitcoin from a man in Poland.

Mr. Andresen makes clear that he is not drawing a parallel with the "responsible" people who run the Fed. "But there are places in the world where the government hasn't been so responsible, like Zimbabwe. And actually before they got to those bills I think they knocked nine zeros off of their old currency."

He adds that he would "not be at all surprised if Bitcoin really took off in a big way in some other part of the world first." He's thinking of places where few people have bank accounts or credit cards "and the currency is just as volatile as Bitcoin has been," he adds with a laugh. During the recent panic in Cyprus, the surging value of Bitcoin captured much media attention. But Mr. Andresen says the gains then were not likely to have resulted from Cypriots seeking a better currency, as some had speculated. Instead, he suspects that spike came from traders sensing an opportunity and perhaps some Spanish, Italians and Russians wondering about the value of their assets.

The reality is that, unlike Ben Bernanke at the Fed, Mr. Andresen is not in charge of Bitcoin. No one is—unless you count
Satoshi Nakamoto,
the name used for the creator of this new form of money. But that person may or may not even exist. (Mr. Andresen says he hasn't heard from the person or people known online as
Satoshi Nakomoto
in a couple of years, and as far as he knows neither has anyone else at the Bitcoin Foundation.) But the software that this mysterious figure created is what makes Bitcoin, or something like it, an intriguing potential medium of exchange, particularly given the transparent plan for creating a fixed amount of currency.

It is perhaps a laughable commentary on the current mania for monetary stimulus that this feature is what seems to have inspired the most criticism of Bitcoin. The knock on Bitcoin is that its fixed nature will cause an inevitable destructive deflation. As more people use the currency, demand for Bitcoins will grow beyond the finite supply and force up the value of each one, which will force the prices of goods to fall over time. This is portrayed as a recipe for economic disaster by those who like to inflate currencies to relieve the burden on borrowers, including spendthrift governments.

It's true that deflations have sometimes accompanied economic disaster, but also economic triumphs. For example, in "Money, Markets & Sovereignty,"
Benn Steil
and Manuel Hinds describe the second phase of the Industrial Revolution in the U.S. between 1870 and 1896. Prices fell by 32% over the period, but real income soared 110% amid robust economic growth, expanded trade and enormous innovation in telecommunications and other industries.

Over a lunch of lamb stew at a French restaurant in Amherst's downtown, Mr. Andresen considers deflation. He is open about the fact that he owned Bitcoins for years before they became his monthly pay, and he would be among those benefiting from a deflation that makes each Bitcoin more valuable. But he also notes potential general benefits from deflation. If prices are falling, he says, it does encourage people to save instead of spend, because the currency will be worth more later. It encourages people to lend instead of borrow.

And for those who wish to avoid both inflation and deflation, what about a digital currency programmed to maintain stable prices, avoiding mischief by central bankers as well as the possibility of deflation? He says the engineer in him likes the simplicity of Bitcoin's fixed money supply.

It's almost time for Mr. Andresen to get back to work. He shares some useful advice about Bitcoin: "I tell people it's still an experiment and only invest time or money you could afford to lose." If only investors could as easily follow that advice with fiat currencies.

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